I want to say this carefully. This is not an optimistic "stay the course" post and it's not a pessimistic "OMG do something" post. It's directed at people who are feeling very uncomfortable. I want to point out some things to think about, things that are hopefully truisms that everyone can see are correct once they're pointed out.

Your investment plan needs to be in tune with your own personal willingness to take financial risk. Your tolerance for financial risk is what it is. Only you know what it is. Nobody else can tell you what it should be. Different people are really and truly different. And your tolerance for financial risk is not necessarily the same as your tolerance for other kinds of risk.

You may not know what stock market risk is really like, and you may not know what your own risk tolerance really is. This is, if nothing else, a good opportunity to assess both.

What we have today is about a 10-15% decline in the S&P over the last month or so, coupled with a feeling of seismic shifts in the financial world. A sense that the earth is moving under our feet. A sense that events are happening that are going to make it into the history books. The general mood is summarized in this headline:

Heralds new era! Strong stuff. Let's not argue about whether it's true or not, let's agree that it feels that way right now. Like there's been a turning point, a division between an old era and a new era, and therefore past history is no longer a guide to the future.

And here's my point: it always feels that way. That's always what a big downturn feels like. It's not a number, 10% or 15%. It's a sense that there's been a break, the ground has shifted, the rules have changed.

We love drama and after the fact the reality often turns out to be boring. Imagine thinking that, see, it wasn't so bad! But that's later. And sometimes it is a turning point and sometimes it is that bad.

When you're deciding what your risk tolerance is, it's not a tolerance for the number 10 or the number 15 or the number 25. It's not a tolerance for an "A" turning into a "+". It's a tolerance for accepting genuinely-scary, nothing-like-this-has-ever-happened-before, heralds-a-new-era news events.

Now, the next set of truisms. Nobody knows what's going to happen. No, really. I don't care what the best experts are saying or what the futures do or what happens tonight in Asia. On Monday, stocks might shoot right back up. Or they might plunge some more. Or they might diddle around for weeks leaving us all on tenterhooks and then plunge some more, Or not.

We see this:

Well, we really don't know what will happen. It might be almost nothing... it might be like the start of this period in 1998 and it could bounce back in a few months.

It might be the start of another 50% plunge like 2008-2009. Awful, but over in a couple of years.

It might be like the start of this period in 1937 when stocks plunged about 50% as in 2008-9, but didn't come back for about a decade. (I'm using a long-lived stock market mutual fund as a proxy for "the market," but it's close enough).

It might be like Japan in 1990, down for two decades and still down.

But not to overweight the pessimism, let me add one more chart. Where's last week's plunge? When I expand the scale, it's actually there. The data being plotted includes it. But apparently it's so tiny it just gets rounded off or vanishes at screen pixel resolution!

The point is, the last few weeks were a time when some risk showed up, and your job is to process it. The temptation is to deal with the discomfort by choosing a prediction. Don't. Your job is to confront the reality of that uncertainty, that you do not know what will happen, and can only make the roughest guesses as to the likelihood of all these scenarios.

Hopefully, you can say "well, yeah, I knew all that. I'd much rather see the market go up and I feel anxious, but I'm able to stay the course."

Unfortunately, if you look at all this and conclude that your exposure to the stock market is higher than your risk tolerance, there aren't any good options. It is absolutely a personal decision. The only sure way to reduce stock market risk substantially is to cut back on your stock allocation. Diversification, fiddling around with different flavors of stock, it's all bandaids. When stocks plunge, they plunge. So the S&P drops 50% and your portfolio drops 46%, big deal.

And when the stock market is falling, you can't cut back on your stock market risk without locking in a loss. It's a tough one and a personal decision. You absolutely have to measure one against the other. It's crazy to even suggest a course of action to anyone else and I'm not going to try.

What I'm saying is that this is a good time for evaluation. The risk is here. Don't exaggerate it--we all love drama, but reality is usually more boring than we expect. Don't brush it aside, look it in the eye as carefully as you can. And then look at how you really feel about it--not how you'd like to feel or how you think you're supposed to feel.

And one final thought. If we're lucky, and the stock market comes back at least part way and seems to stabilize for a while... or if it comes roaring back and soars (yes, that' could happen, too)... don't forget how you feel right now. If you feel that you are close to the edge of your risk tolerance right now, then you have too much in stocks. If you manage to tough it out and we get a calm spell, don't forget how you feel now and at least consider making an adjustment then.

The point is, the last few weeks were a time when some risk showed up, and your job is to process it. The temptation is to deal with the discomfort by choosing a prediction. Don't. Your job is to confront the reality of that uncertainty, that you do not know what will happen, and can only make the roughest guesses as to the likelihood of all these scenarios.

Nisiprius:

I know how long it must have taken you to prepare your post containing the beautiful charts and valuable ideas (like the idea above).

Your contributions to the Boglehead Forum are making us all better investors.

Timely post!
As you and others have mentioned in other threads, it is surprising how many investors on the board are reacting to this, in light of how recent '08-'09 was.

Two especially good points (IMHO):

Heralds new era! ...

And here's my point: it always feels that way. That's always what a big downturn feels like. It's not a number, 10% or 15%. It's a sense that there's been a break, the ground has shifted, the rules have changed.

and

Now, the next set of truisms. Nobody knows what's going to happen. No, really. I don't care what the best experts are saying or what the futures do or what happens tonight in Asia.

and another point:

The only sure way to reduce stock market risk substantially is to cut back on your stock allocation. Diversification, fiddling around with different flavors of stock, it's all bandaids. When stocks plunge, they plunge. So the S&P drops 50% and your portfolio drops 46%, big deal.

Wonder how all those people who had been advocating high-dividend stocks as an alternative to boring old bonds are feeling right now?

Such a well done, well thought-out, and well written post nisiprius. I hope something like this gets incorporated into the wiki so it doesn't get lost over time. Because sure as this crisis will pass, down the road we'll find ourselves in yet another with the same questions being asked.

Thank you, nisiprius, for a well-written post and sharing your wisdom. I don't know what tomorrow brings and your post is so timely in this difficult financial times we are in. I know I will re-read this post many times.

I seldom post but thoroughly read this forum everyday and I can't tell you how valuable your posts are! I may sometimes skim posts by some but always thoroughly read yours as I know they are always informative/educational. I have no doubt there are numerous others out there who mostly read with little or no participation like myself who also value your contributions. Please keep up the great work knowing you are helping so many people!

nisiprius wrote:....What we have today is about a 10-15% decline in the S&P over the last month or so, coupled with a feeling of seismic shifts in the financial world. A sense that the earth is moving under our feet. A sense that events are happening that are going to make it into the history books. ....

Good stuff. Thanks for the commentary. However, I'm surprised you did not show a chart of 2010 about a year ago, but instead you started further back. From April 2010 to July 2010, there was also lots of gnashing of teeth when the market dropped 15%. August 2010 was not too pretty either.

What was the forum pulse back then? Lots of "flash crash" doom and gloom I suppose.

Nisiprius wrote:Heralds new era! Strong stuff. Let's not argue about whether it's true or not, let's agree that it feels that way right now. Like there's been a turning point, a division between an old era and a new era, and therefore past history is no longer a guide to the future.

And here's my point: it always feels that way.

Nisiprius wrote:Hopefully, you can say "well, yeah, I knew all that. I'd much rather see the market go up and I feel anxious, but I'm able to stay the course."

Great post.

Good points.

"Everything should be as simple as it is, but not simpler." - Albert Einstein |
Wiki article link:Getting Started

I seldom post but thoroughly read this forum everyday and I can't tell you how valuable your posts are! I may sometimes skim posts by some but always thoroughly read yours as I know they are always informative/educational. I have no doubt there are numerous others out there who mostly read with little or no participation like myself who also value your contributions. Please keep up the great work knowing you are helping so many people!

I am in the same category. Thanks, nisiprius!

" ... advice is most useful and at its best, not when it is telling you what to do, but when it is illuminating aspects of the situation you hadn't thought about." --nisiprius

Truly an approach to investing for our new age, where it's not about preserving assets or making profits. Instead, it's all about how you feel. Will you get scared into selling low? That's okay, if it makes you feel better. Seems pretty screwy, to me, but appropriate for the times.

Thank you Nisiprius for providing these words of wisdom, guidance and sound advice during these suddenly challenging times. You are absolutely correct about not moving out of stocks as the market is falling. You do lock in your losses.

I was almost in 100% stocks in 2007/2008 (before I found the Bogleheads) and did not know any better. I rode the market all the way down and back up without selling. When calm began to ensue in the market, at about 3/4 of the way back up to last week's level, I balanced more into bonds in several stages. I just moved from 30% to 40% bonds about three weeks ago because I was very uncomfortable with the greater number of bad economic reports and with a market that was bouncing around a bit, without going higher, just like about 3 years ago.

The Bogelheads Forum is instrumental in my understanding of the way one should invest.

Dieharder wrote:The most important thing is to understand and admit that we are powerless to change the course of events that already happened, reducing stocks at this point is sure disaster.

This.

It's best to let the market roll on while you do something else. Let your dividends and capital gains buy you more shares on a much cheaper basis. Go about your business and let all the drama flow by without you getting caught up in it.

Life is good, so we all ought to enjoy it while we can. The market will continue to do its thing and we should do ours.

I would like to add my thanks for all the work you put into making this forum so good. I, also, read your posts and always come away with some new or improved or refined insight. I have no idea what is going to happen with the financial markets but because of the investing education that I have received on this site, I have learned that what is out of my control is out of my control. For the last few years I have worked on developing a comfortable AA and it has provided a level of comfort during this skid. My risk level is about 60/40 fixed and I am prepared to roll with that into retirement in a few years.

I remarked to my wife yesterday that I was surprising calm during this chaotic market and we agreed that it was because of an AA that is reasonable for us. Thanks, again, for your efforts and your wisdom.

You "take it off the table" when others are pumping Mr. Market UP. I took a goodly chunk off back on February 18, 2011. In my humble opinion, now is the wrong time to bail. If anything, you should be a buyer of equities.

In any event, where would you stash it, assuming you took some off the table? There really aren't many good fixed-income options these days. With a CD coming due the end of this month, I am painfully aware of the fixed-income market.

Bad news for the economy generally means tough times for stocks. But history shows that when a country loses its AAA credit rating, it's not necessarily terrible news for that nation's stock market. Stay the course

Nisi, Excellent post! I do have concerns about the market and the potential for a steep decline in stock prices. I have had these concerns since the end of last year and still have them. Initially, my concerns were based on valuations, regardless of economic conditions, which were reasonably good at the end of last year. Now with valuations a little better but economic conditions deteriorating, I still have concerns. Not sure if my concerns are less than, greater than or the same as at the end of the year, though. I have addressed these concerns by adjusting my asset allocation. Towards the end of last year, I was 100% invested in equities and had been for almost 20 years. Since then, I have reduced equity exposure to be more in line with a balanced portfolio. Bonds aren't cheap either but I am hoping they will continue to provide some protection.

Nicely done, well timed. A long post that obviously took you some time, but it's short enough for those who skip or have not had time to learn risk fundamentals to read and understand.

Judging from posts on the forum, I would guess about 50-60% of investors have a fair idea of their risk (loss) tolerance, 10% are knowingly risk averse, and 30-40% overestimate their untested ability to hold though a major downdraft. A high percentage of new investor's preconceived risk tolerance is notoriously overly optimistic and unreliable for selecting an AA because it is based on experiences in life unrelated to investing. It's not just the loss, but a substantial loss coupled with the major pressure and interference of panic and noise from the media and other investors that creates fear and doubt..and failure.

Paul

When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

my read on the forum is that for the VAST majority of this forum, this is not our first rodeo

that being said, participating in drama/doom-gloom/hand-wringing is probably human nature

we had an interesting thread re: capitulation I saw maybe 6 months back, it's worth a read, and probably speaks more to how we collectively act vs how we publicly discuss our fears/worst case scenarios...

Excellent post and answers to the comment someone stated in a different thread on why we keep mentioning "stay the course?". This post and following comments answers why. Fear is an emotion and a powerful one. It does not matter if we understand the importance of staying the course based on all the logic we have read in books. What helps the most is when you have others you believe in (using herd mentality to our advantage) to reinforce what you are doing is the right thing.

One comment on Nisi's is so good that it should be people's signature line:

"We love drama and after the fact the reality often turns out to be boring."

The late Harry Browne used to espouse this point. Things always feel like things are different, but in the world of investing they rarely are.

Jeremy Seigel adviced in this own book, "Stocks for the Long Run" to re-read his chapter on the long term return of stocks when periods like this occurs to keep things in perspective. I did just that this weekend and it removed all doubt that this will pass like many other "end of the world episodes" that have come before and likely will come again.

Bogleheads forum is an excellent way to help use herd mentality to reinforce concepts that get lost during times like this. For that I am thankful to Nisi and the other great contributors to this forum!!

Good luck.

"The stock market [fluctuation], therefore, is noise. A giant distraction from the business of investing.” |
-Jack Bogle

nisiprius, I don't know you, but I like you. Your reasoning skills are Superior to most. In the scheme of time this market isn't special. We all knew markets go & down or pulsate much like are blood pressure through out the day. If we have followed the Bogleheads forums for long, then were set in a manor that adjust our investments based on risk/returns. It doesn't matter to me what happens tomorrow because I'm setup correctly in the first place for my risk tolerance. Your charts are a wonderful look from outside the current situation into the longer term painting of reality.

Reading your post is like viewing a Twilight zone rerun, and knowing the ending. Thank you for you contribution to my investment world. I appreciate your effort more than you can understand.

Knowledge is knowing that the Tomato is a fruit. Wisdom is knowing better than to put the tomato in a fruit salad.

Thank you. I've struggled to understand risk tolerance. I've been looking for a formula, something that can tell me with certainty what my exposure to the stock market should be. This post helps me more than anything else I've read to grasp that *uncertainty* is at the heart of the matter.

I do hope this post goes into the wiki for the topic on risk tolerance.